Yuan Is Now An IMF Elite Currency

Yuan Is Now An IMF Elite Currency

What That Means for Investors

The Chinese government has reached a long sought-after financial goal. The International Monetary Fund (IMF) has given the yuan elite currency status. It now joins the U.S. dollar, the euro, British pound, and the Japanese yen in the basket of currencies that enjoy Special Drawing Rights (SDR). The yuan is now included in the calculations for the value of SDRs.

Think of SDRs as a form of currency that serves as a monetary reserve to IMF member governments. The value of SDRs is determined by weighted rates for all the currencies in the basket. Any member of the IMF can use SDRs to convert their currency into any one of the basket currencies to meet payment requirements. In essence, this keeps market liquidity in a time of free-floating currencies.

By definition, a currency must be freely tradable to meet IMF criteria for SDR, and it is questionable at best that China meets that criteria. The IMF has chosen to give the yuan SDR status in spite of this sentiment. Christine Lagarde, the managing director of the IMF, referred to the move as "an important milestone in the integration of the Chinese economy into the global financial system." Essentially, it represents an expectation (or perhaps hope) that the Chinese economy will open up to outside trade and investment as befitting a nation with an elite currency.

The U.S. government, among others, has complained that the Chinese uses currency manipulation (especially devaluation) to their advantage. However, the previous government-controlled exchange methods are slowly evolving toward a freer currency.

Chinese government officials removed a peg to the U.S. dollar in 2005, and recently took one large step toward currency reform by using the yuan's closing value for a day as the mid-point for the exchange rate range for the next day's trading session. Previously, Chinese officials set the midpoint daily using their own criteria to maintain a range that is related to the dollar yet not directly pegged to it. Using the yuan's closing value as the mid-point removed another barrier to SDR status, although it is still a stretch to call the yuan a free-trading currency.

What Will Happen As A Result Of the Yuan's New Status?

Perhaps not much in the short term, but the longer term may bring more substantial changes. AXA Investment Managers suggest that a minimum of $1 trillion of global reserves will transfer to Chinese assets — although the transition will not be immediate. International Finance Corp. suggests that yuan-denominated securities issued in China by foreign corporations (known colloquially as "panda bonds") have the potential to top $50 billion in the next five years. However, all of these actions presume that China will continue to follow through with steps toward financial reforms and a more transparent economy.

As for the yuan itself, its fate may finally reflect more of market value than government manipulation. The yuan is often rumored to be undervalued to make Chinese exports more attractive. However, given the slowing of the Chinese economy, it is reasonable to expect the yuan to fall further through natural market forces.

China's economy is undergoing a transition away from massive government investment and exports, to a more service-based economy. The extent and predictability of this demand should eventually help the yuan find its equilibrium.

Can Chinese authorities resist the urge to continually manipulate the currency behind the scenes and instead choose the path of transparency and market forces? The yuan's new status makes it more likely that they will move in that direction, but Chinese government actions are generally hard to predict. Let's see what the next few months bring on the Chinese fiscal front.